As soon as the sharemarket comes off even slightly, the Australian media gets hell bent on calling shares a bargain and an opportunity not to be missed. Journalists forget the fact that the sharemarket moves in cycles – quite lengthy cycles – and that successful investors are those who understand and navigate these longer-term cycles rather than getting caught up in the madness and hysteria along the way.
Today we are in the midst of a secular bear market, which may last until 2020, according to financial author John Mauldin, of “Endgame: The end of the debt supercycle and how it changes everything.” Maudlin says that investors should forget about share prices and focus instead on price/earnings ratios because that’s how you determine the end of a secular bear market and the beginning of a secular bull.
The price/earnings ratio is calculated by dividing the market price of an individual stock or a market (such as the All Ordinaries Index) by its earnings per share, either trailing earnings (the last four quarters) or forecasted earnings (the coming four quarters). Forecasted earnings tend to offer a better gauge since what’s done is done; since we’re trying to forecast the future, forward earnings are preferable.
Secular bears begin with high P/E valuations and continue until valuations get too low. Based on data spanning 110 years, Maudlin says that the average bear or bull cycle lasts 13 years. The first cycle in the twentieth century, between 1901 and 1921, was a bear cycle. It started with the P/E ratio peaking at 23, and cumulated in the P/E ratio floundering at 5. During those two decades, market volatility was extreme, with annual returns plunging by -38% some years, only to be greeted with 82% returns the year after. There were many times in the cycle where journalists declared ‘the end of the bear’ only to see prices retreat harshly the following year. Investors who left their money in the market permanently from beginning to end, made a paltry 2% in total.
Mauldin notes that during secular bear cycles, the economy and earnings will grow, however P/E valuations will decline.
Interestingly, Mauldin goes on to say that the years 1933-36 were during a secular bull. “We think of those times as the heart of the Depression,” he says. “But P/E ratios rose from single digits to 19, and the market triped in just a short time.’
The key signal of the beginning of a bull cycle is that markets will have single-digit P/E ratios. “With no exception,” argues Mauldin. “No secular bull market ever began with high P/E ratios, even though significant rallies often started from high P/E ratios. The lesson of history is that all periods of high valuations come to an unhappy end.”
So based on this theory, what’s the current P/E of the Australian sharemarket? The P/E of the Australian sharemarket has retreated over the past few years, currently sitting between 10 and 11 times compared to the long-term P/E of between 14 and 15 times.
The chart below shows the forward P/E of the Australian sharemarket between 1990 and 2011; as you can see the P/E peaked at a touch over 20, falling to single-digit figures at the height of the financial crisis in 2009. Based on Mauldin’s theory, we’d want to see the P/E retreat to single digit P/Es for some time before we can start confidently calling it the death of the bear.
The credit crisis in Europe and the US poses extra problems, however, according to Mauldin. The world economy is just coming out of a credit-fuelled bubble. “The aftermath of a credit-crisis recession is a lengthy period, maybe as much as ten years, where all sorts of markets are more volatile and there are more frequent recessions,” he says. He expects two recessions in the US between now and the end of the decade.
“Think about the period from 1966 through 1982,” he says. “Four recessions, volatility, and P/E ratios ending up at 7, as Business Week famously declared ‘The End of Equities’ on its cover. Who wanted to own stocks? Investors were disgusted.
Could that happen this decade? I think it is very possible. The stock market goes sideways and P/E ratios keep marching right on down, as we go through two more recessions and people get disgusted with stocks, just like in the early ’80s.”
He says that if the US Government gets its fiscal house in order, we’d witness a true boom in the 2020s. “It is once again the Roaring 20s,” he says.
So, indeed, due to the develeraging cycle that’s playing out globally – including Australia – this current secular bear market could last longer than expected.
During the ensuing years, some years will post positive returns, and particular shares will roar up the charts, but the overall trend will be down until the bull emerges. Investors need to become familiar with the P/E ratio of the market and use it – rather than price – as an idicator of where we currently sit on the long-term cycle.
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